Smart Portfolios: A practical guide to building and maintaining intelligent investment portfolios

By Robert Carver

Smart Portfolios is about building and maintaining smart investment portfolios. At its heart are the three key questions every investor needs to answer:

1. What to invest in.
2. How much to invest.
3. When to make changes to a portfolio.

Author Robert Carver addresses these three areas by providing a single integrated approach to portfolio management. He shows how to follow a step-by-step process to build a multi-asset investment portfolio, and how to rebalance the portfolio efficiently. He covers both investment in collective funds like ETFs, and also direct investment in individual equities.

Important features include:

-- Why forecasting future returns is so difficult, and how to account for uncertainty when making investment decisions.
-- How to accurately calculate the true costs of an investment, including costs that you may not even be aware of.
-- How to select the best ETF for each asset class.
-- How to compare the costs and other features of different ETFs.
-- How to select individual shares.
-- Calculating the number of shares needed for adequate diversification.
-- How to use systematic forecasting algorithms to adjust portfolio allocations.
-- How to cut trading costs through smart rebalancing strategies and execution tactics.

Robert Carver also explains how to blend assets with different levels of risk, and how to construct portfolios that suit the level of risk that the investor can cope with.

Smart Portfolios is detailed, comprehensive, and full of practical methods, rules of thumb and techniques, all fully explained with examples. It is intended for professional investors worldwide, including financial advisors, private bankers, wealth managers and institutional funds; as well as experienced private investors.

• Language: English
• Publisher: Harriman House
• Release date: Sep 18, 2017
• ISBN: 9780857195722

Robert Carver

Robert Carver was brought up in Cyprus, Turkey and India. Educated at the Scuola Medici, Florence, and Durham University, where he read Oriental Studies and Politics, he taught English in a maximum security gaol in Australia and worked as a BBC World Service reporter in Eastern Europe and the Levant. Four of his plays have been broadcast by the BBC. He has written for the Sunday Times, the Observer, the Daily Telegraph and other papers and is the author of The Accursed Mountains (Flamingo 1999)

Book preview

Contributors.

Contents

About the author

Note about this eBook edition

Preface

Who should read this book

Finding your way around

What’s in this book

Introduction

Investing today

Why this book?

Is this book still relevant?

Prologue: What do we know?

What we probably don’t know: future average returns

What we probably know: similarity and risk

What we definitely know: costs

What we might, perhaps know: forecasting returns

Part One: Theory of Smart Portfolios

Chapter One: What is the Best Portfolio?

Chapter overview

Geometric mean return

Expectations

Risk and investment horizon

Costs

Real returns

Embarrassment: absolute returns versus relative returns

Currency

A purely financial judgement

Key points

Chapter Two: Uncertainty and Investment

Chapter overview

The investment game

Statistical modelling

The uncertain past

Key points

Chapter Three: Trying to Find the Best Portfolio

Chapter overview

Portfolio optimisation, made simple

Uncertain returns and unstable portfolios

Why the future won’t be like the past

Key points

Chapter Four: Simple, Smart, and Safe Methods to find the Best Portfolio (Without Costs)

Chapter overview

Dealing with different risk appetites

Risk weighting

The handcrafting method

Some practical issues with portfolio allocation

Key points

Chapter Five: Smart Thinking About Costs

Chapter overview

Why costs are important

Cost measurement

How to compare the costs of different ETFs

How much does it cost to diversify an ETF portfolio?

A warning about cost comparisons

Smart tactics for reducing costs

Key points

Chapter Six: The Unknown Benefits and Known Costs of Diversification

Chapter overview

Diversification: What is it good for?

Should you diversify?

The different costs of ETFs and individual shares

Handcrafting, equal weighting, or market cap weighting?

Buy the whole index, or just part of it?

The smartest way to invest in a given country

Does diversifying by buying multiple funds make sense?

Key points

Part Two: Creating Smart Portfolios

Chapter Seven: A Top-Down Approach to Building Smart Portfolios

Chapter overview

Why is top-down smart?

The top-down portfolio

The road map

Issues to consider

Chapter Eight: Asset Classes

Chapter overview

Which asset classes?

What division of asset classes?

What appetite for risk?

The smart way to weight asset classes

How should smaller investors weight their portfolio and get exposure to asset classes?

Summary

Chapter Nine: Alternatives

Chapter overview

Different groups of alternatives

Genuine alternatives

Equity-like alternatives

Bond-like alternatives

Alternative assets for ETF investors

Summary

Chapter Ten: Equities Across Countries

Chapter overview

How to structure an equity portfolio

My framework for top-down allocation in equities

Summary

Chapter Eleven: Equities Within Countries

Chapter overview

Allocating to sectors within a country

Allocating to individual equities within sectors

Ethical investment

Summary

Chapter Twelve: Bonds

Chapter overview

The world of bonds

How to get exposure to bonds

How to weight bonds – in theory

Weighting bonds for US investors

Weighting bonds for UK investors

Summary

Chapter Thirteen: Putting It All Together

Chapter overview

Example 1: Sarah – US institutional investor

Example 2: David – UK investor with £500,000

Example 3: Paul – US investor with $40,000

Example 4: Patricia – UK investor with £50,000

Summary

Part Three: Predicting Returns

Chapter Fourteen: Predicting Returns and Selecting Assets

Chapter overview

Why predicting risk-adjusted returns is so difficult

How can we use smart forecasting models to construct portfolios?

Introducing two smart forecasting models

Using forecasting models in a top-down handcrafted portfolio

Adjusting portfolio weights when you don’t have a model

Stock selection when you don’t have a model

Summary

Chapter Fifteen: Are Active Fund Managers Really Geniuses? And is Smart Beta Really Smart?

Chapter overview

Active fund managers

Smart beta

Robo advisors

Summary

Part Four: Smart Rebalancing

Chapter Sixteen: The Theory of Rebalancing

Chapter overview

Why do you need to rebalance?

Is it worth reweighting and by how much?

When to substitute and when not to

Tax considerations

Summary

Chapter Seventeen: Portfolio Maintenance

Chapter overview

Annual review

Reacting to external events

Periodic portfolio reweighting

Tax implications of portfolio maintenance

Rebalancing example

Summary

Chapter Eighteen: Portfolio Repair

Chapter overview

What is portfolio repair?

A six-step plan for portfolio repair

Some practical points on repair

Portfolio repair example

Summary

Epilogue

Glossary

Appendices

Appendix A: Resources

Further reading

Websites

Appendix B: Cost and Return Statistics

Trading costs

Standard deviations

Correlations

Appendix C: Technical Stuff

Aggregate returns

Standard deviation

Geometric means, standard deviations, and Sharpe Ratio

Gaussian distributions

Correlations

Bootstrapping and sampling distributions

Portfolio optimisation

Forecasting models

Acknowledgements

Reference

Investor types and recommended portfolios

Costs

Minimum investments

Choosing ETFs

Information for weighting

About the author

Robert Carver is an independent investor, trader and writer. He spent over a decade working in the City of London before retiring from the industry in 2013. Robert initially traded exotic derivative products for Barclays Investment Bank and then worked as a portfolio manager for AHL – one of the world’s largest hedge funds – before, during and after the global financial meltdown of 2008. He was responsible for the creation of AHL’s fundamental global macro strategy, and then managed the fund’s multi-billion dollar fixed income portfolio.

Robert has Bachelors and Masters degrees in Economics. His first book Systematic Trading: A unique new method for designing trading and investing systems was published in 2015. Robert manages his own portfolio of equities, funds and futures using the methods you can find in his books.

Note about this eBook edition

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Apportion what you have into seven, or even eight parts, because you do not know what disaster might befall the land.

— Ecclesiastes 11:2 (New Standard Version)

"I only have one piece of advice. Diversify.

And if I had to offer a second piece of advice, it would be: Remember that the future will not necessarily be like the past. Therefore we should diversify.

— Harry Markowitz, pioneer of portfolio theory

"Fund consultants like to require style boxes such as ‘long-short,’ ‘macro,’ ‘international equities.’ At Berkshire our only style box is ‘smart.’"

— Warren Buffett, Annual letter to Berkshire Hathaway shareholders, February 2011

Preface

This book is about answering three deceptively simple questions:

What should you invest in?

How much of your money should you put into each investment?

Should you subsequently make changes to your investments through further buying or selling?

All these questions involve trade-offs: the world of investment is a place without free lunches, and where you can’t eat all your cake and expect to have leftovers.

For example: should you invest in the portfolio with the highest return, the lowest risk, or some mixture of the two? Is buying a couple of investment funds sufficient, or is it worth creating a highly diversified portfolio, splitting your cash between dozens or even hundreds of funds and individual shares? Do you need to constantly buy and sell to make the highest returns, or should you save on brokerage costs and do nothing? Are the higher costs of actively managed funds justified by higher returns?

Making smart investment decisions also means worrying about uncertainty. Those who regard themselves as financial experts – such as journalists, economists and fund managers – continuously make highly confident predictions about what will happen in financial markets tomorrow, next week, or next year. But in reality the future is unclear and forecasting incredibly hard.

Life would be very easy if you knew with 100% certainty that bonds will definitely do better than stocks next year. But what should you do if there is only a 55% chance of bonds outperforming – and how do you calculate that probability?

My aim in this book is to provide an accessible and practical guide to creating and managing smart portfolios which can deal with the trade-offs and uncertainties of the real world. There are no fancy equations, and no prior knowledge of financial theory or statistics is required. Constructing and managing portfolios doesn’t have to be rocket science – you just need to be a bit smarter.

I will show you simple methods to create the portfolio that suits you best – regardless of how comfortable you are with risk, how much money you have to invest, what funds and equities you can buy, and how predictable future returns are.

The world of investment is more diverse than ever, but also more complicated. This book will help you navigate that world.

Who should read this book

The general principles in the book should be applicable to investors in most countries. The examples are drawn from the US and the UK because of the wide range of Exchange Traded Funds¹ (ETFs) that are available in these countries, and because of my own personal experience. Nevertheless all the techniques I describe can be easily adapted for use elsewhere.

1. An ETF is a kind of investment fund which can be traded and owned like a normal equity. Normally ETFs are used for straightforward investments like tracking stock market indices, and are relatively cheap to own.

This book is primarily intended for professionals who are paid to manage other people’s money, from financial advisors (who could be managing relatively small accounts of tens of thousands of dollars or pounds), private bankers and wealth managers; right through to institutional funds (which I would define as managing at least ten million dollars or pounds). In addition, experienced private investors should find much of value in the approaches I describe here.

I believe it is useful for all investors to understand the difference between managing small portfolios and large ones, and for this reason the example portfolios I use start at a few hundred dollars and pounds, and go up to one billion dollars. Throughout the book I’ll explain the different implications of paying retail brokerage costs or managing huge institutional funds.

The book is intended for experienced investors, so I don’t cover the detailed mechanics of how shares are purchased, or how ETFs and other kinds of funds work. If this is an area where you need to do some background reading then Appendix A contains a selection of books that will help fill any gaps in your knowledge.

Even experts in portfolio construction techniques should find this book worthwhile. I think we all need reminding that the models used in finance are based on assumptions that are usually wrong, and often dangerous.²

2. There are also a number of technical footnotes sprinkled throughout the book to keep more knowledgeable readers interested.

Finally, the methods in this book can be applied to any type of portfolio, containing one or more different kinds of asset.³ In particular, I show you how to invest in collective funds like ETFs, but also directly in individual equities. I also explain how and when it makes sense to combine these approaches.

3. Technical note: So in principle specialist institutional managers can use it to create single country equity portfolios or allocate across global equities. However the methods are most valuable when applied in a top level asset allocation problem where you start with a clean slate, and then allocate the portfolio amongst asset classes, and then within them.

Finding your way around

Although I’ve tried to use a minimum of jargon it’s impossible to avoid completely. Often it’s easier to use a short phrase containing one or two words rather than writing long complicated sentences. I have defined any technical terms at the point of first use. There is also a glossary at the end of the book in case you miss, or forget, those definitions.

Some key concepts will need more than just a footnote or glossary entry to explain. For those I’ll use concept sections, like the one you can see below.

CONCEPT: This is an example of a concept section

These sections contain very important concepts which you need to understand. Notice the use of a different font here.

It’s vital that you understand everything in the concept sections. The same cannot be said of digression sections, like this one:

DIGRESSION: This is an example of a digression section

These sections contain material that is interesting and will be useful for some readers, but they are not essential reading if you’re short of time. Notice the use of a different font here.

What’s in this book

This book is divided into four parts. The first part covers the essential theory. Don’t panic: I have included the absolute minimum of theoretical mumbo jumbo as my intention is to give you an intuitive understanding rather than bombarding you with dozens of equations. But it’s important to understand the basics of why certain portfolios are better than others, what effect uncertainty has on the choice of the best portfolio, and how costs affect these decisions.

Part two is about applying that theory to create portfolios using a top-down process.

A top-down process involves starting with the big decisions before moving on to smaller ones. The biggest investment decision is which asset classes you want to own, such as bonds and equities, and how to divide your portfolio between them. Then you should look at how the equity part of your portfolio should be carved up, and the same for bonds. As I’ll explain later in the book, the top-down approach is the best way of getting the most diversified portfolio for the amount of capital you have.

In the first two parts of the book I assume that future returns can’t be predicted and will be identical for all the assets in your portfolio.⁴ But in part three I discuss what you should do with your portfolio if you think you or others can predict future returns to some degree.

4. Technical note: Actually I assume that risk-adjusted returns are identical. You will understand the distinction after reading chapter three.

I explain some forecasting models I use to predict returns and demonstrate their use, as well as how to safely incorporate your own judgment into portfolio selection. I show you how you can evaluate actively managed⁵ mutual funds and unit trusts, and decide if they are worthy of inclusion in your investment shopping basket. By the end of part three you’ll also know some jargon: you’ll understand what smart beta is, what constitutes robo advice, and be able to evaluate these fashionable new trends in investment.

5. An example of a passive investment is an ETF that just invests in an index like the S&P 500 or FTSE 100. These are normally relatively cheap, with low annual management fees. An active fund manager will buy a different portfolio and try to outperform the index. This normally costs more.

In part four I look at what you should do after you’ve built your portfolio. It would be nice if you could just sit back and watch your investments grow, but in practice life isn’t that straightforward. Some trading is occasionally necessary to keep your portfolio on an even keel and to stop it becoming unbalanced. Part four explains how to do this rebalancing without it costing you a fortune in brokerage commissions and other costs. I also show you how to minimise your tax bill.

Appendix A points you towards some useful resources, including other books and websites that might be worth reading, and several data sources. Appendix B lists the assumptions I use in the book about costs and the behavior of different kinds of assets. Appendix C contains technical details for the skilled enthusiasts who want to go beyond the basic techniques I present in the main body of the book.

At the end of the book is a short reference section which contains copies of useful tables and other information.

There is also a website for this book: www.systematicmoney.org/smart. This contains links to spreadsheets with further example portfolios, other sheets to help you build your own portfolios, and some to help you implement the techniques in Appendix C.

Introduction

Investing today

One of my favorite books on investment is titled Simple But Not Easy by Richard Oldfield. Investment has never been easy, but it used to be much simpler.

Twenty-five years ago investors had few options. Most people relied on professional fund managers to look after their money and these managers charged fat fees for their expertise. But with high equity returns this didn’t matter so much. If you were earning 10% a year on your investments, paying 2% to an expert manager seemed reasonable.

Braver souls went out on their own and invested directly into portfolios of shares. With wide spreads and chunky brokerage commissions this wasn’t a cheap option either, especially if you churned your portfolio with frequent buying and selling. Fortunately the extra costs of frequent trading were masked by the upward march of the stock market; just like fund management charges were.

Most investors stuck to firms listed in their domestic market: much easier than trying to buy equities listed in a foreign country, and the fantastic returns available locally were more than enough. Academic researchers call this effect home bias.

Widows, orphans and others of a nervous disposition preferred to own bonds. Their pedestrian returns were scoffed at by the brainwashed disciples of the cult of equities. Few embraced the mixed portfolios of bonds and stocks that academic researchers advocated. As the brokers and fund managers might have asked, when did you last see a professor of economics driving a Porsche?

As for more esoteric investments like hedge funds, these were the exclusive domain of the rich and well connected.

Things have certainly moved on since then. What if we could acquire a time machine and spirit an investor off the sidewalk of Wall Street or the pavement of the City of London forward to the present day? What changes would they notice, apart from a few new skyscrapers and a less formal dress code?

Firstly, it is a lot cheaper to invest. Thanks to technological innovation and fierce competition, brokerage charges are much lower, especially in the US. However, these apparently great deals can be dangerous. The constant jabbering of market commentators and slick advertising of online stockbrokers is a toxic combination, which can easily lure you into unnecessary buying and selling. Ironically, lower commissions have resulted in most people trading far too much: just like half-price deals in the supermarket encourage shoppers to fill their trolleys to the brim.

In principle though lower costs are a good thing. The fees charged by fund managers are also considerably lower these days. Investors can now choose from a wide range of cheap passive funds that follow a particular index like the S&P 500 or FTSE 100. Competition from passive managers has also helped drive down the fees of active management.

That is the good news. The bad news is that expected returns have become a lot lower and more unpredictable. So although absolute costs are lower, they’re still relatively high once lower expected returns are taken into account.

Why have expected returns fallen? Well, inflation has fallen off a cliff. This is good news in theory, but high past inflation fooled investors into thinking healthy returns were their birthright. It’s no longer safe to assume asset prices will steadily increase year after year.

Indeed a quarter century of steadily rising share prices has been sharply interrupted twice; once in the tech crash of 1999 and then again in 2008. In contrast, bonds have performed incredibly well in the last couple of decades, especially once we account for their lower risk. But this great track record probably won’t last. As I’m writing this book, many bonds have very low or even negative yields, and the fear of inevitable interest rate increases spooks the market.

It was never easy to predict financial market movements; but now the future is more uncertain than ever.

Still, thanks to good bond performance, investing across a diversified portfolio of bonds and stocks has been a very successful strategy over the last 25 years. It is easier than ever to buy such a portfolio because there are far more investment options in the market. Specifically, an exciting new type of passive investment fund appeared in 1993: Exchange Traded Funds (ETFs).

Exchange Traded Funds give easy to access stocks, bonds and many other asset classes that the average investor of 25 years ago would have been completely unaware of.

Passive ETFs are much cheaper than the actively managed funds whose performance has rarely justified their heftier fees. Our time traveller from the past might be surprised to find that active funds have not gone away. Perhaps they would have expected a few superstar fund managers to survive the onslaught of passive indexing, but they’d be shocked to find that active managers still control over 70% of the market. The active fund management industry continues to befuddle and bedazzle investors who cannot work out whether promises of higher returns can really justify such premium prices.

ETFs also make it much easier to get exposure to different countries, so in theory at least home bias should be a thing of the past. In practice many people still prefer the comforting familiarity of stocks listed in their home country, or funds covering the same space.

Although I am a big fan of ETFs, most of them have one crucial disadvantage. They give you exposure to a specific index (like the S&P 500 or FTSE 100), made up of fixed weightings in particular securities. These indices are normally weighted by market capitalisation (market cap): the more valuable the firm, the larger the weight. There is fierce debate amongst academic researchers and industry insiders as to whether this is the best possible weighting scheme.

There are other ways of weighting firms in indices and recently ETFs have appeared to implement them. For example, in many countries you can opt for an equally weighted fund where each firm in an index has the same weight, regardless of size.

Plenty of fund managers now also offer something called smart beta. The more complex flavors of smart beta sit somewhere between active management and passively tracking the performance of a particular index to get beta; the finance industry’s fancy term for market capitalization-weighted exposure. I’ll talk about smart beta much more in part three.

There are also currency hedged ETFs, leveraged ETFs, inverse ETFs, target retirement ETFs, long:short ETFs, commodity ETFs, and volatility ETFs. I probably missed some. No doubt there will be a few more kinds of ETFs out by the time you read this.

All this choice is a good thing, but our investor from the past will be frozen into inaction by the sheer variety of what is now on offer in the investment marketplace. Indeed, any thoughtful investor of the present day should feel exactly the same way.

A highly diversified portfolio of stocks and bonds, spread across many countries, is more accessible than before. But what is the best way of achieving it? Funds or individual shares? Active funds or passive ETFs? Passive market cap indexing, or one of the numerous alternatives? Should we buy and hold forever, or actively trade?

Also, what exactly does a highly diversified portfolio look like? What proportion of stocks, bonds and other kinds of assets should it contain? How much should you allocate to each country or industry? Should you try to pick individual stocks? All these options involve different trade-offs between costs and benefits. Which is best?

Finally, without the comfort blanket of a permanent bull market, future returns seem more uncertain than ever. How should you adapt your portfolio to reflect this uncertainty?

Their head spinning with confusion, our visitor from the past runs back into their time machine and slams the door; desperate to return to the comforting simplicity of the past.

Why this book?

Numerous books have been written in the last 20 years to help investors make sense of the changing and ever more complex number of investment options. Why have I written another one – and why should you read it?

Smart: not highly technical or overly simplistic

Many books promote one of two extreme views about portfolio building: it’s either a black art requiring advanced mathematics to grasp, or a trivial problem requiring you to buy a small portfolio of ETFs regardless of how much you have to invest. The truth is more nuanced.

The standard method for finding the best portfolio is indeed relatively complex, but it isn’t necessary to use it, and it may even be dangerous to do so. On the other hand, a portfolio comprised of a small number of ETFs is fine if you have just a few hundred dollars or pounds, but investors with more money can do better.

In contrast to those two polar approaches, this book is about being smart: not overly technical, and not too simplistic. It’s smart to have an intuitive understanding of the relevant financial theory, and in part one I explain that theory in an accessible way. It’s smart to use straightforward methods that are consistent with the right theory, and it’s smart to use simple rules of thumb to help you make decisions. This book is full of methods, and rules of thumb; all fully explained with examples.

I give you smart techniques to build your portfolio, but also to rebalance it in the most efficient fashion. You’ll understand why all investors should own some equities, but why a portfolio with 100% equities is never justified. I also explain thoroughly why diversification is the most important attribute in a smart portfolio, and the best way to achieve it.

A single integrated approach to building your portfolio

There are many great books on investing in shares, deciding your asset allocation, investing in ETFs, and on picking active fund managers. However, I think what an investor really needs is a single integrated approach with a framework that works for their entire portfolio. This book describes such an approach – which UK and US based investors can use to build multi-asset portfolios. These portfolios can consist of ETFs, active funds and equities; or a combination of all three.

I give you simple rules to determine whether you should be investing directly in shares, or in ETFs, and how many funds or shares you should buy. Plus I explain how you can compare cheaper passive ETFs and more expensive actively managed funds.

I address important questions including: how should you select the best ETF? How should you compare the costs and other features of different ETFs? Are new fangled smart beta ETFs worth buying? What are the hidden pitfalls of inverse ETFs, leveraged ETFs, commodity ETFs, and currency hedged ETFs? Is robo investing worth paying for? How many shares do you need to buy for adequate diversification? How should you select those shares? Should you invest in alternative assets, and if so how?

Finally I explain how to blend assets with different levels of risk, and how to construct portfolios that suit the level of risk that the investor can cope with.

Uncertainty

There is one key factor which is almost completely overlooked in most books on investment: uncertainty. Predicting the future is much harder than most people think. Historical data on returns contains much less useful data than you might expect. In this book I discuss the reasons why forecasting returns is so difficult. I also explain the importance of slow moving economic trends such as the multi-decade fall in inflation, and how this makes the past less relevant today.

Only once you are used to thinking about the world in uncertain terms can you start making the right decisions. For example, an active fund is outperforming its passive benchmark, despite charging considerably more. But is that down to luck, or is it skill? I provide you with tools to answer this and other similar questions.

Although the future is uncertain there are important degrees of uncertainty. Some properties of future returns are more predictable than others: how risky different assets are, and how similar they are likely to perform. I show you how to use these more reliable kinds of information when you’re constructing your own portfolios. Finally, I also cover the use of systematic forecasting algorithms, and plain old human gut feel, when trying to predict the future.

Costs

Until quite recently most investors ignored costs, preferring to focus on increasing returns. However, many people are now realising that costs are very important; unlike uncertain returns they are highly predictable, and lowering costs is the easiest way to increase the returns on your portfolio. Mostly the advice given to investors keen on paying less for their investment is to stick to passive ETFs.

This is pretty good advice, but there is much more to using costs to make the right investment decisions. First of all you need the right data, so I show you how to calculate the true costs of your investments to a high degree of accuracy, including invisible costs that are usually ignored or hidden from view. Secondly you need to understand how costs affect small retail and large institutional investors differently. Thirdly you need to think about trade-offs between costs and potential benefits, many of which are uncertain.

Important trade-offs that I discuss include: the cost and benefits of diversification, whether smart beta funds and active funds are worth buying given their higher charges, and how many funds or shares you should buy given the size of your investment portfolio.

I also explain how you can reduce your trading costs through smart rebalancing strategies to reduce the volume of trades you need to do, and smart execution tactics to reduce the costs of each of those trades.

Is this book still relevant?

I finished writing this book in the summer of 2017. Most of what I say here will hopefully still be useful in 2027, 2037, and beyond – assuming it stays in print that long! For example, I make some assumptions about future returns in different asset classes, but these are just arbitrary figures which make the results I show you easier to interpret:⁶ my findings aren’t affected if you use different assumptions.

6. Technical note: Relative returns adjusted for risk are what is important, and I usually assume these can’t be predicted, and are identical across different assets.

However, there are some details which won’t age so well. For example, I name specific ETFs; in the future these could close down, or better funds could turn up. To help you out I’ll explain how you should research new ETFs and what features you should be looking for. There is detailed advice given throughout on selecting ETFs, with a summary on page 554.

Also, many of the decisions in this book are based on cost figures, which will be different if you use a more expensive broker than I do, or if brokerage charges change in the future. I’ll explain how you should adapt my findings to reflect different levels of commissions.

Prologue: What do we know?

Investment is a risky business: it involves making decisions that will expose our hard earned wealth to an uncertain future. Before making these decisions it’s worth thinking about how much we know, or don’t know, about what will happen in the future.

What we probably don’t know: future average returns

Typical conversation between me and a new acquaintance at a wedding, party, baptism or bar mitzvah:

Them: So what do you do?

Me: Well I used to work for a hedge fund. Now I trade my own money, write books and do some consultancy.

Them: So you’re an expert on finance! Do you mind if ...

Me: (hastily interrupting) I wouldn’t say I was an expert exactly...

Them: (not listening) … I ask you for some advice?

Here are some genuine questions I’ve had from friends, relatives, and random people I have met at social events:

What is going to happen in Greece? Will the bond market rebound?

Now then, what do you think about Japan? Should I sell my Japanese investment trusts?

Do you think I should invest in bamboo? (I wish I was making this one up.)

All these people are assuming that an expert should be able to give them expert advice. I usually politely refuse, which causes surprise and sometimes offends.

This is a common problem. Here is a quote from philosopher-trader Nassim Taleb’s book Fooled by Randomness:

One day a friend of my father… called me during his New York visit... he wanted to pick my brain on the state of a collection of financial markets… I was not interested in markets (‘yes, I am a trader’) and did not make predictions, period… it almost damaged the relationship... for the gentleman called him with the following grievance ‘When I ask a lawyer a legal question, he answers me with courtesy and precision. When I ask a doctor a medical question, he gives me his opinion… Your indolent and conceited 29-year-old son is playing prima donna and refuses to answer me about the direction of the market!’

Why do Nassim and myself refuse to give our ‘expert’ opinion? Let’s look again at the list of questions above and I will rephrase them slightly:

Predict what is going to happen to the price of Greek bonds in the future.

Predict what will happen to the price of Japanese investment trusts in the future.

Predict what will happen to the price of bamboo in the future.

In order to give my expert opinion I have to predict the future of asset prices. This is difficult. It’s much more difficult to predict the future of market prices or economic data than it is to solve a legal or medical problem.

In fact the state of economic and financial prediction in the 21st century is similar to that of medicine in the 18th century. Doctors bled the patient with leeches⁷ and if they recovered doctors claimed all the credit. But if they died it was just ‘bad luck’ or ‘unforeseeable circumstances’.

7. I understand that leeches might be making a comeback in medicine, which isn’t something that I’m personally comfortable with.

Similarly, present day market pundits will gracefully take plaudits when they are right, but rarely admit mistakes. Unforeseeable circumstances is no longer an acceptable medical excuse, but economic forecasters still use it frequently. Some will get it right more often than not, but with enough people trying, the laws of probability will always grant a select few a run of good luck they can attribute to their own skill.

Unlike medicine, financial forecasting has hardly progressed during the 240 years that have passed since economist Adam Smith wrote The Wealth of Nations, and effectively founded modern economics whilst his medical contemporaries were busy bleeding their patients.

Here is a selection of particularly poor forecasts over the years:

Stocks have reached what looks like a permanently high plateau.

— Irving Fisher, Professor of Economics at Yale, three days before Black Thursday in 1929, the most devastating stock market crash in US history.

Stocks are now in the midst of a one-time-only rise to much higher ground–to the neighborhood of 36,000 on the Dow Jones industrial average.

— James Glassman and Kevin Hassett writing in 1999. Shortly afterwards the Dow peaked at just under 11,500 before falling to 7600.

It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of these transactions.

— Joseph Cassano, head of US insurance giant AIG’s financial product division, speaking in 2007. One year later AIG was bankrupt and had to be rescued by the US government in a $180 billion bailout.

The Federal Reserve is not currently forecasting a recession.

— Ben Bernanke, head of the US Federal Reserve, and supposedly the most knowledgeable economist in the world, speaking on 10 January 2008. A few months later the US National Bureau of Economic Research declared that the US was already in recession when this speech was made.

I think financial and economic forecasting will never reach the accuracy of medical diagnosis. But why is forecasting prices so hard?

Firstly, because financial markets are complex. Of course both doctors and economists study complex systems made up of large numbers of individual elements – organs and cells in medicines; firms and individuals in economics. The difference is that the billions of humans who make up the economy have their own free will, and as a result their behaviour and resulting interactions are extremely unpredictable.

The various parts of the human body mindlessly do the same thing day after day. The body automatically fights off nearly all infections, with only relatively serious diseases or old age requiring external medical intervention. An engineer would describe the body as a stable and self correcting system.

In contrast, as you can see from the quotes above, financial markets are often highly unstable. They have a tendency to try to commit suicide, frequently veering off into huge bubbles followed by deep collapses, which require massive government bailouts to alleviate any effect on the real economy.⁸

8. In one respect things have improved: the response of global governments to the 2008 crash wasn’t perfect, but it was undoubtedly much better than the feeble efforts of 1929 onwards. But what hasn’t changed is that (virtually) nobody saw it coming. Sticking with the medical analogy, economists are like doctors who can now recognise when a patient is about to die, and have worked out how to use a defibrillator to restart their heart, but who were completely oblivious of anything going wrong until the patient was almost on the verge of death.

Secondly, forecasting prices is difficult because not only do you have to predict the future, you need to predict the future better than anyone else. Current market prices already reflect the collective estimate of every investor in the world based on all the information that is currently available.⁹

9. Technical note: You may recognise this as one of the flavours of the efficient market hypothesis.

You might think that shares in Samsung should be cheap because one of their smart phones has an unfortunate habit of spontaneously combusting. But everyone else knows that too and the price of Samsung shares will reflect that information. Without access to inside information that is unknown to others, you can’t accurately predict where prices will go next.

Perhaps you think you can predict what will happen to asset prices if a particular event happens in the future, such as Britain leaving the European Union or Donald J. Trump becoming US President. But unless you can calculate the chance of this event happening better than everyone else, this isn’t going to be a route to instant riches.

As a result it’s very difficult indeed to know what will happen to the price of Greek bonds, Japanese investment trusts, bamboo, or any other financial asset.¹⁰ Smart investors are aware of the terrible track record that humans have of forecasting the market, and are highly sceptical of anyone who claims otherwise. I’ll play it safe and in the first two parts of this book I assume that we can’t predict future returns.¹¹

10. I am generally sceptical of financial experts having some special insight into future price movements but there are some systematic ways to predict prices which may have some value. I talk about these shortly.

11. Technical note: To be pedantic I assume that risk-adjusted returns are identical for all assets.

What we probably know: similarity and risk

All investors know they shouldn’t put all their eggs into one basket. Buying just one type of asset means you’ll be exposed to the risk that it will fall dramatically. Rather than sinking your entire capital into bamboo, Japanese investment trusts, or Greek bonds, you should diversify and buy a portfolio of investments.

Ideally these investments should be as different as possible. A portfolio containing shares in 20 companies might seem highly diversified. But if all those companies are UK clothing retailers you will still be dangerously exposed to a downturn in the British apparel market. You need to spread your money more widely.

Fortunately assets which have had similar returns in the past tend to carry on doing so in the future: similarity is a relatively predictable attribute of prices in financial markets.

We also know that some investments tend to be riskier than others. For example, lending money to the Norwegian government for 12 months, by buying a one-year bond, is incredibly safe. The Norwegian economy is underpinned by huge petroleum reserves and is more than capable of supporting its relatively small population even when oil prices are depressed. The chance of not being paid back in full is negligible. Furthermore, Norwegian interest rates, which will also affect the bond price, aren’t likely to change very much over the course of a year.

Now consider a highly speculative internet start-up, which consists of a few people in a rented office (none of whom have run a business before), a poorly written business plan, and a website address (gr8tplacetobuy5tereo.or.tv) which is hard to type and even harder to remember. Buying shares in this venture would be incredibly risky. There is an infinitesimal chance it will become the next Facebook or Amazon, and a much larger chance you will lose your entire investment.

If you had a $2000 to invest, how much would you put into Norwegian bonds, and what would you invest in gr8tplace? Unless you have a gambling problem you wouldn’t put all your money into gr8tplace. Even someone with a very high tolerance for risk shouldn’t put half into gr8tplace; you’re almost guaranteed to lose 50% of your overall wealth. You’d probably want to have much more than half your investment in safe Norwegian bonds.

Like similarity, risk is relatively predictable – certainly much more predictable than average returns. Whatever happens in the future, bonds issued by stable governments will never be riskier than speculative internet stocks.

Smart investors are happy to assume they can predict the similarity and risk of future returns. In this book I’ll show you how to use these two factors – the things you probably know – to decide which portfolio to invest in.

What we definitely know: costs

In introductory finance courses around the world, students are taught about a theoretical portfolio which contains every tradeable asset in the world:¹² every stock, every bond and every fund... all of which should be traded throughout the day, every day of the year! In reality it’s impossible to own this perfect portfolio. Out in the real world we have to face up to paying costs every time we buy or sell.

12. Technical note: This is the market portfolio of the Capital Asset Pricing Model.

Many costs are fixed, regardless of the size of the transaction. In the UK it currently costs me £6 in commission to buy one share in supermarket Marks & Spencer. Buying just one share in each of the 2400 firms currently listed on the London Stock Exchange would cost over £14,000 in brokerage fees – more than the shares themselves are worth. Trading them every day would cost hundreds of thousands of pounds a year! All this is before we consider investing in multiple countries, or in other asset classes.

Fixed costs make it prohibitively expensive to have portfolios with hundreds of shares. So rather than buying individual shares most investors should buy funds: mutual funds, unit trusts, investment trusts or Exchange Traded Funds (ETFs).¹³ My terminology for these is collective funds because they allow a group of investors to collectively buy small shares of a large portfolio.

13. I go into more detail about the difference between these later.

However